By Paul Broughton, Portfolio ManagerWe finally got a 5% drawdown in the S&P 500 for the first time since October of 2020. From Sept 2nd through Oct 4th, the broad equity market, as reflected in the S&P 500, dropped -5.1%. The month-long decline helped to reset and temper expectations and should be viewed as a normal part of being in the market. The seasonally volatile months of September and October are behind us and we’re now in the market’s seasonally strongest period of the year – the fourth quarter. What are some things investors should be thinking about as we finish out the year and start looking at 2022?
Historically, the S&P 500 since the end of World War II has returned an average of 3.9% in the fourth-quarter and is up 4 out of every 5 years. Year to date, the market is up 24.1% and is trading at about 20.3times 12-month forward earnings. Interestingly, the multiple is essentially flat year to date even though the market has appreciated at over 20% – meaning that earnings growth has at least kept pace with the change in the market price level. Now what about looking forward? The S&P is forecast to deliver earnings of $227.14 in 2022 vs. the $210.38 expected for 2021. That’s as of today. We’ll know more when we get through earnings season as companies report their outlooks on revenues and margins. The current, well documented supply chain issues will obviously greatly impact these potential revenues and margins. So, this $227.14 in ’22 earnings and the market multiple of 20.3x are subject to change in the next few weeks.
The backup in the ports is interesting in that it represents the demand for goods from the American consumer and the ports can’t unload the freight and shipping containers fast enough. And it’s not just the ports that are struggling – we also see businesses across the country struggling to hire workers even at noticeably higher wages. All of this could lead to a rate of inflation that’s more than merely transitory (please see ACM’s Sr. Economic Advisor Dr. Greenspan’s most recent commentary here). That’s where the uncertainty comes in for the forecast of the S&P 500’s earnings for 2022. The market is always worried about something and usually it’s multiple “somethings”. Right now, the primary worry is inflation. U.S. businesses are dealing with it and will pass on the higher costs where they have the ability to do so. The U.S. consumer is experiencing higher food costs and higher energy prices (at the fuel pump in particular). How this inflation affects businesses and the consumer will play out over the next several months and will likely determine how the market performs in 2022.
So, lets look at what the market price action is telling us. Equities? They’re climbing the proverbial wall of worry – despite all of the concerns around higher inflation, labor supply shortages, higher wages, supply chain issues, and talk of potential tax hikes on the way from Washington, the S&P 500 is up 24.1% through Oct 29th. What’s the bond market telling us? Treasury rates have been rising, but modestly and at an orderly pace and they’re still very low and accommodative (especially when looked at relative to where they’ve been over the last five years). The 10yr Treasury is at 1.56%. Pre-Covid it averaged 2.27% for the five years that ended 12/31/2019. And credit spreads, a very important metric that we monitor closely (chart below), are very tight – this is a good indicator that access to capital is available and very affordable for businesses to finance and expand their operations. And what about Covid? The delta variant appears to be on the wane as new cases have rolled over since early September (chart below). With unemployment falling and wages rising, consumers that are relatively healthy and spending, and a low-interest rate environment, the equity market outlook remains positive as we look to the end of 2021 and the first few months of 2022.
HY Credit Spread Index:
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